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January 7, 2011

Outlook 2011, Advisors: Top 10 Challenges for BDs, RIAs, Wirehouses

Finding alpha, conducting due diligence, fiduciary and budget woes top the year's challenges for all advisors

Forecasting is always a messy, inexact business, whether you’re discussing investment returns or Super Bowl winners. The primary benefit advisors provide is to increase the chances that their clients will achieve their financial goals—and increasingly these days, their overall life goals—despite the essential unknowability of the future.

With that caveat in mind, the editors of AdvisorOne,Investment Advisor and Research magazines present their consensus choices for the 10 biggest challenges advisors will face in the new year. These are practice management issues and portfolio construction issues. They are local issues—down to the state and municipal levels—and global issues. These are technical issues and interpersonal ones. In other words, they touch all the areas where advisors operate.

Close contenders for the Top Challenges included achieving true client data aggregation—a technological and business development opportunity for many advisors—and the higher profile but challenge of finding appropriate fixed income, to name just two.

Challenge No. 1: Finding Alpha in a Slow-Growth Economy

The proliferation of ETFs and ETNs based on narrower and narrower indexed slices of the overall market (such as on the VIX), a recent upsurge in new mutual funds of all kinds, the growing interest in hedging strategies and the resurgent interest in hard assets like precious metals all attest to increased advisor interest in, and challenges around, finding alpha in new ways and through new vehicles.

Adding a fillip of investing returns to portfolios that since the 2008-2009 markets and economic crisis are much more attuned to risk management is not a simple task, especially when you take into consideration investors’ herd mentality (see top issues Number Five below) and the financial services marketing machines that push investing vehicles that promise outsize returns with minimal risk.

Gil Weinreich (left),editor of Research magazine and Portfolio channel editor for AdvisorOne, points out, however, that while “Maintaining beta doesn’t have the same glory as the search for alpha, it’s important in any market.” He recalls Warren Buffett’s two rules of investing:

Rule No. 1: Never lose money.

Rule No. 2: Never forget rule No. 1.

Weinreich says that “once the client’s portfolio is sensible and secure, the fun begins with the smaller pool of capital committed to alpha.” His “personal guess” is that advisors will increasingly find alpha in the commodities sphere, perhaps in “commercially viable shale oil production that lessens our dependence on foreign imports, or in some sort of natural product that can help sugar-addicted Americans enjoy tasty foods without the negative health consequences.”

Challenge No. 2: Due Diligence on Investment Managers and Vehicles

A related issue to the search for alpha is the quest for trust. A primary contributor to the market and economic crisis of 2008-2009 was not simply the securitization of mortgages gone awry, but the lack of transparency into those securities. Do you still trust the ratings agencies? Do you still trust money market funds? Do you trust all kinds of private partnerships? Do you trust the announced earnings of public companies? In your search for alpha, do you rely on internal due diligencers, or do you outsource that heavy responsibility?

In her analysis of the data gathered to create the annual Top Wealth Managers list, Kate McBride (left), editor of AdvisorOne’s wealth channel, notes that the most successful wealth managers bring much of their due diligence work in-house. That strategy is an underpinning of the trust relationship with clients, and reflects the larger sizes in AUM of the Top Wealth Managers, but it also may well be a sign that you’re not only serving the high-net-worth, but doing it well. If you outsource, with whom do you do so? Those companies that perform due diligence on behalf of advisors of all kinds should thrive.

Challenge No. 3: A New SRO for Advisors?

Perhaps within a week’s time from writing this article, we will know whether the SEC has recommended a new regulator for RIAs under its mandate arising from the Dodd-Frank reform law, and whether that SRO will be FINRA, which has been lobbying for such a role for years. (In fact, we may know as early as Jan. 14 what the SEC will recommend).

The FSI, the independent broker-dealer group, formally endorsed FINRA for the role on Dec. 20. In doing so, Dale Brown (left), FSI's president and CEO, said picking FINRA would be “best for investors, since it addresses the most significant problem in the current structure: the huge gap between how broker-dealers are regulated and how investment advisors are regulated.”

Other advisor advocacy groups—particularly those in the Financial Planning Coalition, such as FPA and the CFP Board—reject FINRA for the role. The broker-dealer community, while not totally happy with FINRA, believes naming it the SRO will help create a level regulatory playing field for all RIAs and BD reps. There are rumblings that the SEC will instead recommend another group to serve as regulator—perhaps the CFP Board in some capacity?—but regardless of who is chosen, the regulatory scheme for RIAs is likely to change. Stay tuned.

Challenge No. 4: State, Local and Federal Government Budget Woes

Gil Weinreich weighs in on this issue forcefully, saying that 2011 “can make or break America’s economic future.”Research magazine’s long-tenured editor says “We’ve gotten ourselves into a fiscal trap, where any necessary corrective moves we make will create other problems. If we raise taxes for the increased revenue we need, we will further weaken the private sector, thereby stunting job growth. Yet insufficient revenues adversely affect America’s credit rating.”

What’s the result? Weinreich worries that a “crippling” increase in our borrowing costs will negate any conceivable benefit of past stimulus measures. “Getting out of this pickle,” he says, artfully mixing metaphors, “will take the dexterity of entangled porcupines. Failure to get out will have the same catastrophic consequences as Greece and Ireland are currently experiencing.”

Challenge No. 5: A Fiduciary Standard for All

The controversy over the adoption of a single, strong fiduciary standard for all advice givers has perhaps produced more heat than light, though considering the strong feelings involved, it’s understandable. Many non-RIAs, especially reps in the independent broker-dealer world, have already adopted a de facto fiduciary standard, and for years some IBDs have welcomed reps that have their own RIAs, not to mention a firm like LPL which already has a healthy custodian operation for its reps who are RIAs, and for non-LPL reps as well.

As with most standards, the devil of a fiduciary duty being imposed for all will be in the details. We’ll begin to see those details by Dec. 21 when by another Dodd-Frank mandate the SEC must present its recommendations on the matter to Congress.

Gil Weinreich has this to say about the wirehouses and a fiduciary standard: “Wirehouse advisors may have no choice but to make a virtue out of necessity,” adding that “now’s the time to let clients know they will adopt business practices that unambiguously put their clients’ interests ahead of their own.”

While Weinreich admits that such an approach “could cost them in the short-term, they may soon have no choice, and it’s never a bad thing to demonstrate a moral commitment to clients.” He recommends that wirehouse advisors “Might as well blaze the fiduciary trail before the rest of the thundering herd.”

Yes, managing client expectations is an evergreen issue for advisors, but coming out of the financial crisis with lowered expectations for economic growth that would help clients recoup their losses from the crisis presents a unique challenge. Tie that together with the level of partisan bickering in Washington over taxes and budgets echoed in many states where wealthy clients and advisors live and work—think Illinois, California, New York and New Jersey, for starters—and you have the makings of a toxic brew.

AdvisorOne’s Joyce Hanson suggests that when advisors are speaking to clients in 2011, they should “watch for signs of ‘frugality fatigue,’ ” which she defines as the feeling experienced by many of the wealthy that they scrimped and saved all through the recession, “even if they didn’t have to, and now they want to go back to having a bit of fun with their money.”

A Gallup poll, she points out, discovered evidence of this: By the middle of 2010, upper-income Americans said they were shelling out 33% more on daily spending, at an average of $145 per day in May compared to $109 in April, even while middle- and lower-income spending was unchanged. What should you look for? “Beware of frugality fatigue translating into clients’ impulsive purchases,” Hanson warns, “of big-ticket items or hot stocks.”

Challenge No. 7: Cost Gains Reporting

One technical issue in 2011 that has “significant implications” for both RIAs and broker-dealers, says Maggie Serravalli of Fidelity Institutional, are the new cost-basis reporting requirements from the IRS.Investment Advisor managing editor Danielle Andrus quoted Serravalli in a mid-December article on AdvisorOne that those implications include “costs associated with operational changes to educating staff and clients." Fidelity, other RIA custodians and broker-dealers have been educating advisors about the new cost-basis reporting rules. A report from Fidelity Institutional lists the following six changes.

The preamble to the final IRS regulations clarifies that although allowable, it is not required for brokers to accept standing instructions for alternative cost-basis disposal methods (ADMs) for client accounts.

Beginning Jan. 1, 2011, an average cost election is no longer binding.

The final IRS regulations now require brokers to apply fair market value (FMV) as of the date of death to inherited securities when determining the cost basis for assets transferred from a decedent account.

The final regs continue to require brokers to capture and maintain both the carryover basis (i.e., the donor’s cost basis) and the fair market value as of the date of the gift.

The final regulations provide penalty relief for transferors with missing cost basis through 2011.(See the full article for more details.)

Challenge No. 8: New Form ADV Part II, and Custody of Assets/Surprise Audits

Moreover, those advisors who are deemed to have custody will be required to reflect that fact on the recently amended Form ADV . The amended custody rule, Giachetti wrote, “requires an advisor to engage an independent CPA to commence an initial annual surprise examination no later than Dec. 31, 2010, and for that CPA to then file the corresponding initial Form ADV-E no later than April 30, 2011."

That’s not the only change for Form ADV.

In a series of articles, we wrote about the changes coming to Form ADV Part II, including a two-part blog by David Tittsworth (left) of the Investment Advisers Association. Tittsworth argued that the SEC mandate on Form ADV Part II did not constitute “a cosmetic change, but a true overhaul,” and reminded readers that the new Part II is “not a regulation that only compliance officers should fret about.”

Among its requirements for all to fret over: a plain-English narrative describing the RIA firm’s business practices and conflicts of interest, covering 18 topics, and details about every individual in the advisory firm who will interact with clients. Washington insider Tittsworth also noted that this year the SEC may well institute a new set of changes to Form ADV, Part 1.

Challenge No. 9: European—and Euro—Troubles

“The lack of political unity,” says James Dailey (left), “is likely to be the downfall of the euro.” We quoted Dailey, of Team Financial in Harrisburg, Pa., at the tail end of November 2010 as the sovereign debt issues of multiple countries in the eurozone took center stage. Commenting on the European Union’s bailout of Ireland and its troubled banks, Dailey said then he suspects that “the more these kinds of arrangements are made, the greater the likelihood of widespread political/societal upheaval” on the continent.

Research’s Weinreich has his own take on the Euro-woes. Writing at the end of December, Weinreich argued that “Greece, Ireland—and soon Portugal, Spain and perhaps Italy and Belgium—will be losing the essence of sovereignty, that is, the ability to project their national values through their own chosen budgetary priorities. The Germans, Dutch and other nations that impose austerity will in effect lose a measure of their own independence because they will be committing their resources to foreigners.”

With an eye to the “arc of European history,” Weinreich warned that “what starts out as an economic crisis may arouse demagoguery, ethnic tension, instability and violence. Europe’s teeming immigrant populations will surely be drawn into the coming maelstrom.”

Challenge No. 10: The New Generation, and Succession Planning

When it comes to evergreen issues for advisors, no topic is more timely and pressing than easing the exit strategies of advisor pioneers and “replacing” those departing advisors with a new generation of advice givers. It’s an issue Mark Tibergien (left) of Pershing has preached for years: that there is a talent shortage in the industry that will only grow larger as the baby boomers age and seek advice, and as those pioneers of the industry—the average age of a practicing advisor is somewhere in the mid-50s now—make their ways to the exit.

According to data compiled by Schwab Institutional and reported by Schwab’s Dave DeVoe blogging in AdvisorOne, 2010 was likely a record year for RIA firm acquisitions. As we reported in our Top Five Practice Management stories of 2010, many independent BDs have instituted succession planning programs for their independent contractor reps and there are more and better ties being formed between academia and practitioners to help nurture the next generation of advisors. But more needs to be done.

Whether evergreen or just a’borning, whether domestic or international in nature, these are the challenges that advisors will face in 2011.

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